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Guest post: Cantillon and Central Banking (by Justin Merrill)

Lately there has been somewhat of a debate between some Market Monetarists and some Austrians about the so-called Cantillon effect. I have not participated in the debated – last time I wrote about the Cantillon effect was actually in my Master thesis on Austrian Business Cycle theory in the mid-1990s and to be frank I have not made up my mind entirely on this discussion. Therefore, I am happy Justin Merrill have written a guest post for my blog on the topic.

As it is always the case I do not necessarily agree with what the authors of guest posts on my blog write, but I always hope that guest posts can help further the debate about monetary policy and theory issues. I believe that Justin’s post is doing exactly that.

Please enjoy.

Lars Christensen

Guest post: Cantillon and Central Banking
by Justin Merrill

Much has been written recently on the topic of Cantillon effects. I risk alienating myself by potentially disagreeing with everyone, but I hope I can persuade others to see it my way. At the extremes there are two points of view. The rational expectations view basically asserts that money is neutral when inflation is expected, and therefore the Cantillon effects can largely be ignored. On the other end of the argument is the exploitative theory of state money, whereby the issuer of the currency, the banks, the politically connected, and the government employees and contractors benefit at the expense of everyone else. While both of these have nuggets of truth, they also have flaws that make them inapplicable to our current monetary system.

After a careful rereading of Sheldon Richman’s article, I agree with it almost entirely with the exception of one part:

“Since Fed-created money reaches particular privileged interests before it filters through the economy, early recipients—banks, securities dealers, government contractors—have the benefit of increased purchasing power before prices rise.”

Cross out “government contractors” from the above sentence and it is true. This is because contractors are paid out by the Treasury, which gets the vast majority of its funds from taxation and financing. This confuses fiscal transfers with monetary ones. Since the Treasury does not print money directly a la greenbacks, the government does not receive a 100% seigniorage from central bank operations. A lot of Rothbardians also make the mistake of assuming that all bank credit expansion represents a windfall gain to the issuing bank and the borrower, but this ignores that banks have to pay interest to their depositors and it is not costless to expand.

But are the Market Monetarists right that there are not Cantillon effects from open market operations since primary dealers are selling bonds to buy reserves? Not quite. The primary dealers do benefit by getting the privilege of selling securities at a premium to the market rate and buying at a discount. The gain might be small, but it exists; otherwise PDs would not have an incentive to participate in OMOs. This is effectively a risk free arbitrage that doesn’t arise out of entrepreneurial awareness, but political connectedness and size. Libertarians may overstate the size of this privilege, but it shouldn’t be ignored. Interest paid on reserves to banks and Federal Reserve profits turned over to the US Treasury are also direct injections of new money. The total amount is roughly $100 bil a year (Fed’s reported profits plus its deposit liabilities times .25%), not including the unknown arbitrage gains that PDs make from trading.

Imagine that we are on a gold standard and the price of gold is $1,000/oz. A gold miner may have a cost of production of $990/oz. He therefore earns $10 of purchasing power by adding to the outside money supply.

Now imagine that in our current system a PD buys a security for $990 and sells it to the Fed for $1,000, he also earns $10 of purchasing power.

In both cases of base money expansion, there are Cantillon effects, but the second one is largely due to legal privilege. Once the outside money enters the banking system, there are secondary Cantillon effects. Banks’ cost of capital is lowered, increasing their profit margins. They may increase their investments, benefiting prior holders of said investments, or they may increase their lending, putting new money in the hands of the borrower and shortly into the hands of the person selling the financed asset.

The way that monetary policy transmits can be difficult to predict through the credit channels. Different firms have varying access to capital markets. Small businesses rely on bank and trade credit, while large firms may be able to issue commercial paper at extremely low rates. In a credit crunch, small firms will be cut off from credit even if the Fed is aggressive with monetary policy. The beneficiaries, relatively speaking, will be primary dealers and issuers of commercial paper that can borrow near zero and lend through trade credit at high rates of interest.

This is one reason I am skeptical of NGDP targeting. I do not think output and asset prices can be kept in equilibrium through central banking. Even though I prefer NGDP targeting to inflation targeting, I think stable NGDP is a probable outcome of monetary equilibrium, not an end in itself. The transmission mechanism between reserve creation and output and inflation is messy and unpredictable.

In summary:

1) Don’t confuse fiscal and monetary transfers.

2) Austrians may sometimes be inarticulate at explaining Cantillon effects in our current system (a person counterfeiting money in his basement is not the same as OMOs) but it still exists.

3) Cantillon effects will exist in any system, but their magnitude and consequences are dependent on the institutions.

4) Money is not injected in a “helicopter drop” and should not be assumed neutral through rational expectations.

5) Non-neutral money can create malinvestment through the banking system and credit channels and it matters what the central bank buys and its impact on the yield curve.

9 Comments

bill woolsey

When the government runs a budget deficit, the Fed auctions off Treasury bills to the primary securities dealers. They then sell those bonds to (other) banks, firms, households, foreign central banks, etc.

If the Fed buys some of them instead of someone else, how exactly did this benefit the primary securities dealers?

They are buying the bonds sold by the Fed for the Treasury, and them distributing them to investors. What difference does it make if the Fed is one of the buyers?

Is it really true that there are all sorts of people who would like to get into the business of bidding for bonds in the auctions and then selling them off, but only a special few who have political connections get to participate in the business?

The notion that the we can imagine a ceteris paribus, and then the Fed decides to do an open market purchase, and contacts a special friend to buy the bonds from is unrealistic.

This doesn’t mean there are no effects. Those who would have bought the government bonds that the Fed is buying now have “old money” that they can use to purchase consumer goods, capital goods, or some other financial asset. What they spend the “old money” on is the actual injection effect.

And, treating the decisions of those who would have purchased the goverment as if they are receiving new money as a gift and choosing to buy ice cream or go to the movies is wrongheaded.

If small firms who depend on bank credit have lots of profitable opportuntities, then won’t banks offer to pay relatively high intereset rates on CDs, so those who would have bought the government bonds get those. If, instead, the profit opportuntities are better for larger firms who sell their own commercial paper, won’t they offer to pay relatively more, and so those who would have bought the government bonds with their old money instead buy the commercial paper with the old money?

The notion that new money must enter somewhere and this distorts relative prices is wrongheaded.

That excess supplies of money can push the market interest rate below the natural rate and this causes a change the the pattern of demands based upon relative interest elasticities of demand is correct.

If rational expectations (or something else) keeps the market interest rate from falling, then these effects just don’t occur.

Going back to well, the new money entered someplace and so it must impact relative prices somehow and those receiving the money first most benefit because they spend the money before other prices rise is wrongheaded.

I like this article, but it seems to me that nearly as soon as the Fed announces OMOs, or even sooner on rumor of OMOs, the markets start to move expectations almost immediately – it’s not as if any of this happens in a bubble where the Fed just blindsides everyone and average Joe gets the shaft. I personally think that the Cantilion effect is highly exaggerated; and the counter-intuitive, the tightening of monetary policy at some semblance of equilibrium is where average Joe really gets the shaft. I can’t stress enough how much I detest hard inflation targets come hell or high water; and even if the Cantilion effect exists to the extent its proponents proclaim, it matters not to me as long as there is a society full of opportunity and jobs for those who want them.

Thanks for your comment, Bill. Concerning primary dealers, one of the benefits they get is the spread between what they buy at and what they sell, since at least one half of the process is not a pure market transaction. The PDs get to sell at a premium and buy at a discount to the market price when dealing with the Fed’s trading desk. I’m sorry I don’t have a quantitative study to back up my claim, but it should be apparent since otherwise the PDs would have no incentive to participate. I do have some recent anecdotal evidence that supports my claim. A scroll through POMO transactions show that Fed coupon purchases were almost always at a premium to the market for that day and sales were at a discount. Likewise, Fed repos (draining reserves) are paying rates higher than 1yr T-bills.

There are barriers to entry to becoming a PD that include net capital positions and responsibilities that favor size. The official justification is that PDs are needed as conduits of monetary policy, because we know that large firms like Bear, Lehman, and MF Global are less risky. I support Selgin’s idea to do away with primary dealers and operate more like the ECB does through TAFs with little barriers to entry (collateral).

Bill- “If small firms who depend on bank credit have lots of profitable opportuntities, then won’t banks offer to pay relatively high intereset rates on CDs, so those who would have bought the government bonds get those.”

The problem here is asymmetric information in a financial crises. Financial intermediaries can break down in a liquidity crises and it can be hard to distinguish credit risks from liquidity risks. This is one reason why a firm would ever utilize trade credit of terms 2/10 net 30 (APR of 36.72%), because the bank won’t lend to them.

“Large firms tend to be net providers of trade credit (relatively high receivables), with smaller firms in the user position (relatively high payables).” “Foundations of Financial Management” ed. 14.

Philo

“Now imagine that in our current system a PD buys a security for $990 and sells it to the Fed for $1,000, he also earns $10 of purchasing power.” In practice the spread would be less, and the PD has costs of operation that he has to cover. His profit from the trade will be minuscule. Admittedly it would be better if the Fed bought direct from the Treasury, eliminating the middle man; but it wouldn’t be *much* better.

“Once the outside money enters the banking system, there are secondary Cantillon effects. Banks’ cost of capital is lowered, increasing their profit margins.” The PD deposits the money from the sale to the Fed, then immediately turns around and buys more treasurys to replenish his supply. This might benefit the bank because of economies of scale, but the effect will be even more minuscule. Or the PD might buy a stick of gum with his profits; this would benefit the gum retailer and manufacturer by a yet more minuscule amount.